The Hybrid ARM Is Back – And It’s A Smart, Customizable Mortgage Option
Once upon a time in the mid-1990s — 1994 to be precise — 30-year fixed mortgage rates were hovering in the high single digits and threatening to break the 10% threshold. Some smart guy in some small bank somewhere had an idea for a better mousetrap and the Hybrid ARM was born. Part fixed, part adjustable with an initial “teaser” rate far below 30-year fixed rates, the Hybrid ARMs quickly became the mortgage financing product du jour.
Fast forward to last May, as much noise was swirling around the Fed’s tapering strategy: 30-year fixed rates ascended a full percentage point in less than 30 days, based only on the conversations of the small screen financial talking heads, and all before the Fed announced anything! Not long afterwards, borrowers started to ask me about hybrids. 3/1, 5/1, 7/1, 10/1, what is the spread between the 30-year fixed, what are the caps, what is the index, how do they work?
Let’s review the mechanics:
Hybrid ARMs as the name implies, have a fixed rate component on the front end of the mortgage term (3 years, 5, 7 or 10) and an adjustable rate component on the back end of the mortgage term, when the interest rate can change/adjust annually. For example; a 5/1 ARM in today’s market could have an interest rate that is fixed for the first 5 years at 3.00% compared to a 30-year fixed rate mortgage at 4.50%. For a $200,000 mortgage, that would save $170/month. After 5 years/60 months, the interest will adjust annually based on an index (1 year LIBOR or 1 year Treasury/CMT), plus a margin of somewhere between 2.25% and 2.75%.
Of course there are caps on the interest rate adjustments. Typically the initial adjustment cap is 2% above the start rate, unless the initial term is 5 years or longer, then the initial caps can be as high as 5%. The periodic or yearly caps are typically 2% above (or below) the existing rate and the lifetime cap is 5% or 6% above the initial fixed rate, depending on the term.
Since birth, hybrid ARMs have maintained space on the entrée side of the menu, for a time even expanding to include interest only variations, which have become scarce now that QM is sheriff. While fixed rates have enjoyed a prolonged period of historical lows, the demand for hybrid ARMs has fallen dramatically.